The Theory of Water and Utility Pricing - Global Drinking Water Management and Conservation - page 70

Chapter 5
The Theory of Water and Utility Pricing

5.1 Introduction

In this chapter, we survey the theory and practice of the pricing of water as a public
utility. Section 5.2 reviews the classic theory of marginal cost pricing developed by
Dupuit ( 1854 ) and expanded by Hotelling ( 1938 ). Marginal cost pricing maximizes
consumer welfare and to this day, even after major developments in public eco-
nomics from the 1970s to the present, survives as the most enduring guiding prin-
ciple of utility pricing. Marginal cost pricing requires that the capital costs be
covered by general taxation. In Sects. 5.3 , 5.4 and 5.5 , we consider pricing where the
utility cannot rely on the capital costs being covered by the state or by a higher
jurisdiction; this is Ramsey pricing, an idea that was

first put forward in Ramsey
( 1927 ). In the climate of low taxation, and a declining role of the state, many higher
level jurisdictions now do not offer full coverage of capital costs of the drinking
water treatment plants run by municipalities, and so the latter are obliged to charge
prices higher than marginal costs to cover the capital costs. We consider utility
pricing in the context of recent developments in the public economics that can

be dated as beginning with the work of Mirrlees ( 1971 ), and show that while Ramsey
pricing remains relevant to the modern utility, it can be integrated with the new
public economics by introducing

“ new ”

where state subsidies
can range from positive to zero for capital costs. We restate the reformulated theory
of Ramsey pricing and illustrate diagrammatically the incorporation of shadow
prices. In Sect. 5.6 , Ramsey prices and Shadow Ramsey Pricing are computed using
data from reverse osmosis treatment plants presented in Chap. 3 . Thus this section
demonstrates that utility pricing that is compatible with the new public economics is
possible in practice. In Sect. 5.7 , we consider actual pricing practice in some
developed OECD countries, such as the USA, European Union, and Australia, and
assess how far the practice deviates from the theoretical principles of utility pricing.
Section 5.8 brings together the main lessons for the pricing of water.

“ shadow Ramsey Pricing, ”